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Kroll Gets a License to Shoot (Bonds)

By

Aaron Lucchetti And

Jeannette Neumann

Updated Aug. 30, 2010 12:01 a.m. ET

Onetime corporate sleuth
Jules Kroll
is reinventing himself as an investigator of bonds.

The 69-year-old mogul, who founded and later sold security firm Kroll Inc. for $1.9 billion, acquired boutique credit-ratings firm Lace Financial last week in an effort to build staff and get the licenses needed to compete with the three big rating firms, Standard & Poor's,
Moody's Corp.
MCO -1.14%
and Fitch Ratings.

Jules Kroll made his name in corporate security, not securities.
Getty Images

"There's a need for a credible alternative," said Mr. Kroll, who last year started Kroll Bond Rating Agency Inc. to take on the incumbents. He poured about $5 million of his own money into the venture and hired about a dozen employees, including former executives from Moody's and Fitch, a unit of Fimalac SA of Paris. Then last week he decided with the help of new investors to spend more than $5 million for Lace, a 25-year old company with about a dozen employees that mainly rates banks and other financial-services firms.

One key attraction of Frederick, Md.-based Lace is that it has the regulatory licenses with the Securities and Exchange Commission to be a nationally recognized bond-rating firm. "A lot of investors have no choice but to use" a rating firm recognized by the SEC, said Mr. Kroll from his firm's new office in Midtown Manhattan.

Kroll's Plan

How Kroll's credit-ratings venture will try to stand out:

1. Perform more 'due diligence,' beyond data from bond issuers.

2. Accept much of its pay from investors who subscribe.

3. Provide ratings in some cases when issuers don't want one from Kroll.

4. Provide supporting materials with ratings so investors can see why a rating was given

Mr. Kroll's entry into the business is the latest move by an upstart trying to take advantage of perceived weakness from the three largest credit-rating firms, which have been around for decades and have long dominated their important niche of Wall Street: communicating a bond's risk to investors in a simple alphabetical code.

Regulatory advantages helped maintain the dominance of the big three ratings firms. But in recent years Congress has acted twice to reduce that dominance and open up the market to new entrants. In May, research firm
Morningstar Inc.
MORN -0.31%
paid $52 million to buy Realpoint LLC, which held a license for its work specializing in rating structured-finance transactions.

"It's very clear that major rating firms have not served the market particularly well in the recent past, so it's wonderful that there's some competition for them," said
Sean Egan,
managing director at boutique rating firm Egan-Jones Ratings Co. "They obviously need it."

Egan-Jones, Lace and Realpoint were designated as licensed credit-rating firms after the SEC opened up the field to more players following the passage of a 2006 law.

But that move has done little to chip away at the market share of Moody's, Fitch and S&P, which is owned by
McGraw-Hill Co
s. The three industry leaders issued about 97% of all outstanding ratings across five major debt categories, such as corporate issuers and asset-back securities, in 2008, according to a 2009 report by the SEC.

Not much has changed since then, analysts said. "I don't think Moody's or S&P are losing any sleep on new entrants in this business," said
Michael Meltz,
an equity analyst at
J.P. Morgan Chase
JPM -0.79%
& Co.

Kroll is still a minnow in the world of bond ratings. With Lace, which will maintain its name as a unit of Kroll, the firm will have about two dozen employees, compared with 1,300 credit analysts world-wide at S&P and more than 1,200 at Moody's. Lace had only about $1 million of revenue in 2009 compared with $1.2 billion for Moody's Investors Service and $1.7 billion for the rating unit of Standard & Poor's.

Mr. Kroll said he hopes he can change that market share. In 1972, he started an investigative firm that tapped into a growing need to chase down assets in foreign countries and research the financial strength of companies' suppliers, customers and merger partners. In 2004, he sold the company to Marsh & McLennan Cos. for $1.9 billion, and personally took home about $120 million in the deal. He remained chairman of the firm until 2008, when he left to pursue new business ventures.

Kroll's Team

Senior officials at Kroll Bond Rating Agency and previous jobs they held

James Nadler, President and Chief Operating Officer; former executive vice president, Fitch

At the time, the subprime-mortgage market was imploding, dragging down the rest of the credit markets and later the U.S. economy. At the center of the blame game that followed were the major rating firms, which had stamped thousands of mortgage related bonds with top triple-A marks, before changing course and cutting their ratings when many homeowners stopped paying their bloated mortgage bills.

"We were looking for public-policy problems that needed private-sector solutions," said Mr. Kroll, who is planning to rate residential- and commercial-mortgage bonds later this year. His new ratings business shares office space with the consulting firm he founded, and he expects to erect a wall to separate them.

With the deal last week to buy Lace, Kroll Bond Ratings also accepted $20 million in funding from investors including Bessemer Ventures Partners and RRE Ventures.

The investors are pouring money into a business that faces hurdles, from heavier regulation to efforts by users of bond ratings to find other methods to assess the risk in their portfolios. Mr. Kroll said, for instance, that he has met with representatives from insurance companies to discuss their efforts to rely less on bond ratings.